Financial Innovation in the Management of Catastrophe Risk

Catastrophic events such as hurricane and earthquakes are the dominant source of risk for many property casualty insurers. Primary insurers usually limit the scale and geographic scope of their operations in order to focus on core competencies such as marketing, underwriting and loss control. But his often leaves them without sufficient geographic spread to diversify catastrophe risk. The traditional hedge for the primary insurer is reinsurance. Specialist reinsurers achieve a spacial spread of risk and can therefore bear catastrophe risk that is undiversifiable to the primary. But the transaction costs associated with reinsurance, and therefore premiums, are high. High premiums, coupled with the fact that catastrophe losses exhibit little correlation with capital market indices, has attracted considerable activity in Wall Street in searching for new instruments that securitize catastrophe risk. Indeed many players are now talking of catastrophe risk being a new “asset class” and new instruments such as catastrophe options and catastrophe bonds are starting to appear. The rationale for these new instruments is usually developed as follows. Recent catastrophe events such as Hurricane Andrew and the Northridge earthquake have imposed costs on the insurance industry of an order of magnitude not thought possible only a decade ago. More sophisticated modeling now presents potential losses to the industry of $50 billion or more. Examples would be Andrew hitting Miami, a major quake on the New Madrid Fault and a repeat of the 1906 San Francisco earthquake. These events could wipe out 25$200 billion. Two such events, or one such event combined with continued mass tort claims (e.g. successful plaintiff claims in tobacco litigation) could cripple the whole industry. However, losses of this size would hardly cause a ripple in capital markets. The U.S. capital market currently currently consists of securities representing some $13 trillion of investor wealth and the loss scenarios cited above amount to less than one standard deviation of daily trading volume. Presentations by merchant bankers, reinsurance brokers and others have echoed this potential for diversifying catastrophe risk within the capital market. The high transactions costs of reinsurance offers potential for hedging instruments to be offered to primary insurers that are both competitive with current reinsurance and which offer investors high rates of return. Moreover, since catastrophe risk is uncorrelated with market indices, the benchmark for such investments is just the risk free rate. Pricing new instruments requires that the expected loss be estimated with some. Until recently, insurers and reinsurers had a comparative advantage in information on catastrophic events. But in the past decade a number of modeling firms have developed models that combine seismic and meteorological information with data on the construction, siting, and value of individual buildings. These models can be used to simulate the economic effects of many thousands of storms and earthquakes. Although such models are used by the insurance firms and reinsurers, mainly for loss estimation and re-balancing their exposure, the same models are now available to other companies and investors. The arrival of the modelers and their models is eroding the comparative information advantage of insurers and reinsurers and opening the door to new players. Insurers will retain their comparative advantage over, say, merchant banks in related insurance services such as marketing, underwriting and loss settlement facilities. But the stage has been set for an unbundling of insurance products with insurers retaining marketing underwriting and settlement services and risk bearing by-passing the reinsurance industry and being provided more directly from the capital market. But the combination of high transaction costs for reinsurance and the vast capacity of the capital market for diversification, is not sufficient to ensure the success of these new instruments. The costs associated with reinsurance do not necessarily reflect monopoly rent. Relationships between primary insurers and reinsurers involve moral hazard; the relationship relaxes the incentive for the insurer to underwrite carefully or to settle claims efficiently. Consequently, the reinsurer will monitor the primary. Moreover, long term relationships are often formed to counter such expropriation. The apparently high transaction costs of reinsurance may simply reflect the resolution of moral hazard. If new instruments such as catastrophe options and bonds are to compete successfully with reinsurance, they must be able resolve incentive conflicts between the primary insurer and the ultimate risk bearer. Indeed, if moral hazard is not resolved, using past insurance loss data to estimate the potential returns for purchasers of catastrophe bonds, etc, is spurious. The purpose of this paper is to examine and categorize new catastrophe hedging instruments. These instruments will then be compared with traditional risk management strategies adopted by primary insurers in order to compare their relative efficiency at resolving incentive conflicts. Each instrument offers a different combination of credit risk, basis risk and moral hazard. For example, catastrophe reinsurance is subject to significant credit risk and moral hazard, but does not encounter significant basis risk. I will argue that the differential performance of the traditional and new instruments offers primary insurers with a richer portfolio of risk management strategies, though no strategy is dominant in its performance on all three criteria.

Insuring the uninsurable : brokers and incomplete insurance contracts

How do markets spread risk when events are unknown or unknowable and where not anticipated in an insurance contract? While the policyholder can "hold up" the insurer for extra contractual payments, the continuing gains from trade on a single contract are often too small to yield useful coverage. By acting as a repository of the reputations of the parties, we show the brokers provide a coordinating mechanism to leverage the collective hold up power of policyholders. This extends both the degree of implicit and explicit coverage. The role is reflected in the terms of broker engagement, specifically in the ownership by the broker of the renewal rights. Finally, we argue that brokers can be motivated to play this role when they receive commissions that are contingent on insurer profits. This last feature questions a recent, well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer. Klassifikation: G22, G24, L1

Insurance Contracts and Securitization

High correlations between risks can increase required insurer capital and/orreduce the availability of insurance. For such insurance lines, securitizationis rapidly emerging as an alternative form of risk transfer. The ultimatesuccess of securitization in replacing or complementing traditional insuranceand reinsurance products depends on the ability of securitization to facilitateand/or be facilitated by insurance contracts. We consider how insuredlosses might be decomposed into separate components, one of which is atype of “systemic risk” that is highly correlated amongst insureds. Such acorrelated component might conceivably be hedged directly by individuals,but is more likely to be hedged by the insurer. We examine how insurancecontracts may be designed to allow the insured a mechanism to retain all orpart of the systemic component. Examples are provided, which illustrate ourmethodology in several types of insurance markets subject to systemic risk.

Insuring the Uninsurable: Brokers and Incomplete Insurance Contracts

How do markets spread risk when events are unknown or unknowable and where not anticipated in an insurance contract? While the policyholder can "hold up" the insurer for extra contractual payments, the continuing gains from trade on a single contract are often too small to yield useful coverage. By acting as a repository of the reputations of the parties, we show the brokers provide a coordinating mechanism to leverage the collective hold up power of policyholders. This extends both the degree of implicit and explicit coverage. The role is reflected in the terms of broker engagement, specifically in the ownership by the broker of the renewal rights. Finally, we argue that brokers can be motivated to play this role when they receive commissions that are contingent on insurer profits. This last feature questions a recent, well publicized, attack on broker compensation by New York attorney general, Elliot Spitzer.Incomplete Insurance Contracts, Brokerage, Contingent Commissions, Reputation

Insuring non-verifiable losses

Insurance contracts are often complex and difficult to verify outside the insurance relation. We show that standard one-period insurance policies with an upper limit and a deductible are the optimal incentive-compatible contracts in a competitive market with repeated interaction. Optimal group insurance policies involve a joint upper limit but individual deductibles and insurance brokers can play a role implementing such contracts for the group of clients. Our model provides new insights and predictions about the determinants of insurance

Can Insurers Pay for the "Big One"? Measuring the Capacity of an Insurance Market to Respond to Catastrophic Losses

This paper presents a theoretical and empirical analysis of the capacity of the U.S. property-liability insurance industry to finance major catastrophic property losses. The topic is important because catastrophic events such as the Northridge earthquake and Hurricane Andrew have raised questions about the ability of the insurance industry to respond to the "Big One," usually defined as a hurricane or earthquake in the $100 billion range. At first glance, the U.S. property-liability insurance industry, with equity capital of more than$300 billion, should be able to sustain a loss of this magnitude. However, the reality could be different; depending on the distribution of damage and the spread of coverage as well as the correlations between insurer losses and industry losses. Thus, the prospect of a mega catastrophe brings the real threat of widespread insurance failures and unpaid insurance claims. Our theoretical analysis takes as its starting point the well-known article by Borch (1962), which shows that the Pareto optimal result in a market characterized by risk averse insurers is for each insurer to hold a proportion of the "market portfolio" of insurance contracts. Each insurer pays a proportion of total industry losses; and the industry behaves as a single firm, paying 100 percent of losses up to the point where industry net premiums and equity are exhausted. Borch's theorem gives rise to a natural definition of industry capacity as the amount of industry resources that are deliverable conditional on an industry loss of a given size. In our theoretical analysis, we show that the necessary condition for industry capacity to be maximized is that all insurers hold a proportionate share of the industry underwriting portfolio. The sufficient condition for capacity maximization, given a level of total resources in the industry, is for all insurers to hold a net of reinsurance underwriting portfolio which is perfectly correlated with aggregate industry losses. Based on these theoretical results, we derive an option-like model of insurer responses to catastrophes, leading to an insurer response-function where the total payout, conditional on total industry losses, is a function of the industry and company expected losses, industry and company standard deviation of losses, company net worth, and the correlation between industry and company losses. The industry response function is obtained by summing the company response functions, giving the capacity of the industry to respond to losses of various magnitudes. We utilize 1997 insurer financial statement data to estimate the capacity of the industry to respond to catastrophic losses. Two samples of insurers are utilized - a national sample, to measure the capacity of the industry as a whole to respond to a national event, and a Florida sample, to measure the capacity of the industry to respond to a Florida hurricane. The empirical analysis estimates the capacity of the industry to bear losses ranging from the expected value of loss up to a loss equal to total company resources. We develop a measure of industry efficiency equal to the difference between the loss that would be paid if the industry acts as a single firm and the actual estimated payment based on our option model. The results indicate that national industry efficiency ranges from about 78 to 85 percent, based on catastrophe losses ranging from zero to $300 billion, and from 70 to 77 percent, based on catastrophe losses ranging from$200 to $300 billion. The industry has more than adequate capacity to pay for catastrophes of moderate size. E.g., based on both the national and Florida samples, the industry could pay at least 98.6 percent of a$20 billion catastrophe. For a catastrophe of $100 billion, the industry could pay at least 92.8 percent. However, even if most losses would be paid for an event of this magnitude, a significant number of insolvencies would occur, disrupting the normal functioning of the insurance market, not only for property insurance but also for other coverages. We also compare the capacity of the industry to respond to catastrophic losses based on 1997 capitalization levels with its capacity based on 1991 capitalization levels. The comparison is motivated by the sharp increase in capitalizaiton following Hurricane Andrew and the Northridge earthquake. In 1991, the industry had$.88 in equity capital per dollar of incurred losses, whereas in 1997 this ratio had increased to $1.56. Capacity results based on our model indicate a dramatic increase in capacity between 1991 and 1997. For a catastrophe of$100 billion, our lower bound estimate of industry capacity in 1991 is only 79.6 percent, based on the national sample, compared to 92.8 percent in 1997. For the Florida sample, we estimate that insurers could have paid at least 72.2 percent of a $100 billion catastrophe in 1991 and 89.7 percent in 1997. Thus, the industry is clearly much better capitalized now than it was prior to Andrew. The results suggest that the gaps in catastrophic risk financing are presently not sufficient to justify Federal government intervention in private insurance markets in the form of Federally sponsored catastrophe reinsurance. However, even though the industry could adequately fund the "Big One," doing so would disrupt the functioning of insurance markets and cause price increases for all types of property-liability insurance. Thus, it appears that there is still a gap in capacity that provides a role for privately and publicly traded catastrophic loss derivative contracts.

Information Effect of Entry Into Credit Ratings Market: The Case of Insurers\u27 Ratings

The paper analyzes the effect of competition between credit rating agencies (CRAs) on the information content of ratings. We show that a monopolistic CRA pools sellers into multiple rating classes and has partial market coverage. This provides an opportunity for market entry. The entrant designs a rating scale distinct from that of the incumbent. It targets higher-than-average companies in each rating grade of the incumbent\u27s rating scale and employs more stringent rating standards. We use Standard and Poor\u27s (S&P) entry into the market for insurance ratings previously covered by a monopolist, A.M. Best, to empirically test the impact of entry on the information content of ratings. The empirical analysis reveals that S&P required higher standards to assign a rating similar to the one assigned by A.M. Best and that higher-than-average quality insurers in each rating category of A.M. Best chose to receive a second rating from S&P

The relative success of alternative approaches to strategic information systems planning: an empirical analysis

Strategic information systems planning (SISP) is an exercise or ongoing activity that enables organisations to develop priorities for information systems development. It has been suggested that the ‘SISP approach’, a combination of method, process and implementation, is the most complete way of describing SISP activity. Based upon questionnaire responses from 267 IT Directors, four distinct approaches to SISP have been derived using cluster analysis. A comparison of these four approaches with five approaches of Earl, M.J., 1993. Experiences in SISP, MIS Quarterly, (March), 1–24, indicates that three bear strong similarities to the ‘organisational’, ‘business-led’, and ‘administrative’ approaches, whilst the fourth cluster is related to both Earl’s ‘method-driven’ and ‘technological’ approaches. An analysis of the relationship between SISP approach and SISP success demonstrates that the ‘organisational approach’ is significantly more successful than the other three approaches

Entanglement of indistinguishable particles in condensed matter physics

The concept of entanglement in systems where the particles are indistinguishable has been the subject of much recent interest and controversy. In this paper we study the notion of entanglement of particles introduced by Wiseman and Vaccaro [Phys. Rev. Lett. 91, 097902 (2003)] in several specific physical systems, including some that occur in condensed matter physics. The entanglement of particles is relevant when the identical particles are itinerant and so not distinguished by their position as in spin models. We show that entanglement of particles can behave differently to other approaches that have been used previously, such as entanglement of modes (occupation-number entanglement) and the entanglement in the two-spin reduced density matrix. We argue that the entanglement of particles is what could actually be measured in most experimental scenarios and thus its physical significance is clear. This suggests entanglement of particles may be useful in connecting theoretical and experimental studies of entanglement in condensed matter systems.Comment: 13 pages, 6 figures, comments welcome, published version (minor changes, added references